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Tail risk and asset prices in the short-term

René Garcia

Professor of Financial Economics and Quantitative Methods, Université de Montréal | Scientific Director, SKEMA CANADA

We combine high-frequency stock returns with risk-neutralization to extract the daily common component of tail risks perceived by investors in the cross-section of firms. Our tail risk measure significantly predicts the equity premium and vari- ance risk premium at short-horizons. Furthermore, a long-short portfolio built by sorting stocks on their recent exposure to tail risk generates abnormal returns with respect to standard factor models. Incorporating investors’ preferences via risk- neutralization is fundamental to our findings: the predictive power of the physical tail risk is weaker and generally subsumed by its risk-neutral counterpart.


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